Re:Balance -- Jim Peterson

Accounting Standards: Rules or Principles? Lessons From the UBS Dress Code

Goldman Sachs has snatched from its US clients the windfall chance to front-run Facebook's IPO, by limiting access to the potential of its $1.5 billion special-purpose fund to foreigners -- while professing no influence from the fuss-budgets at the SEC (here). So it seems a good time to ask:

Should regulatory compliance and accounting standards be expressed as detailed codes of precisely-drawn rules? Or as broadly-articulated principles?

There are lessons to be taken from the 43-page dress code issued by Swiss bank UBS in December (here).

The debate needs help: endless, pointless and fruitless, it feeds the conclusion that much-touted but never progressed “convergence” between international accounting standards and country-level codes in Europe, the UK and the US is as distant, elusive and unlikely as ever.

Popular reaction is that only a Swiss mentality could perpetrate the obsession at UBS, with its meticulous prescriptions on suit fabrics, cosmetic colors, collar points and hair care both facial and cranial.

Although, a dress code did appear late in my own corporate life – no less ridiculous but also raising non-trivial dissonant issues about the boundaries and effectiveness of guidance.

I was the senior member and titular head of a team based in Paris – an expatriate American amongst colleagues from the major European countries. To a man and woman, all were immensely talented and hard-working. They were also urbane, stylish and beautifully attired.

Global headquarters in the US published its requirements for the new “business casual.” It was only six single-spaced pages, compared to the fulsome 43 pages of UBS – but who’d have expected better from the sartorially challenged Americans?

It went into gruesome detail on necklines and sleeve styles and degrees of elasticity; it proscribed denim and gym gear and athletic branding; and it forbade flip-flops and open toes and footwear of any aerobic provenance.

On a given day, probably one-third of our Paris team would have been out of compliance. But, making their own individual decisions about skirt lengths, or pantyhose in July, or whether to match an Armani T-shirt with a differently-branded suit, my young charges were always impeccably turned out and appropriate for client premises and boardrooms anywhere.

For the purpose, they were capable of proper judgments under the lightest of guidance. At our annual group party our solicitor from Edinburgh was elegant in his formal tartan kilt, dirk and sporn – but for court he was always in proper dark grey suit. On warm spring days the length of limb on display among our lanky cadre of legal assistants was a substantial percentage of their average 1.8 meters – but they all donned decorous trouser suits when the visiting firemen arrived from America.

Which has what to do with the challenge of setting international accounting standards? The answer starts with the extent of mutual trust and confidence shared by a community seeking for mutually-acceptable guidance and limits.

Our Europeans rightly expressed derision and ridicule for the US code, just as most of the world feels for the pathetic efforts of UBS, because of our expectations for what was important: discipline, dedication and execution of first-quality work. Under broad principles of professionalism and good taste, their public face was virtually one of self-regulation.

Whereas if constrained by punctilious trivialities, they would have wasted both their morale and my goodwill, along with countless hours of productive time, on manipulation of the rules in rebellious search for boundaries and exceptions.

It’s no different with financial reporting standards and regulations. History teaches that bright-line limits are pushed to excess by the creative and the aggressive: the depreciation lives of mainframe computers in the 1970’s, the elastic retained ownership requirements for special-purpose entities exploited by Enron in the 1990’s, the investor limits skirted by Facebook under the counsel of Goldman Sachs.

It is the human condition that some deviance from codes of behavior is inevitable – society decides the amount, by voting its willingness to allocate resources to law enforcement and sanctions.

The range across cultures can be vast – from the de facto legalization of recreational drugs in urban America at one end, to the use of flogging in Singapore to punish the consumption of fast food on the public streets.

At the extreme, drunken driving among teen-agers could be eliminated: raise the driving age to 25 and impose capital punishment on first offenders. No less, accounting manipulations could be wiped out – by outlawing commercial transactions in more than one currency or that fail to settle for cash within 48 hours.

But the compromises required of society would never go so far. Instead, the certainty of occasional lapses and excesses is accepted. Limits are broadly defined, and enforcement mechanisms are calibrated -- for both better andworse -- in both the capital market’s use of financial information and the fashion decisions of a business office.

Judged by my experience in the latter, a global environment is far more seemly and operates with more success without the heavy hand of excess regulation.

That will soon be learned, I wager, in the halls of UBS. Whether the new leaders of the Financial Accounting Standards Board and the International Accounting Standards Board will agree is a matter of greater doubt.

 

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Holiday Gifts in Bernie Madoff's Bankruptcy: A Widow Does Her Bit -- and the Banks Will Too

 Holiday gifts arrived early in December for the circle of players around the wreckage that was Bernie Madoff. There are several lessons.

First, the widow of Madoff’s ur-client Jeffrey Picower redefined the landscape of civil forfeitures by agreeing with Madoff trustee Irving Picard to turn over an astonishing $7.2 billion – said to be her late husband’s entire take from a 35-year relationship (here).

Second, Picard himself dumped sacks of coal and lawsuits into the stockings of the Madoff enablers – notably including Unicredit, JPMorgan Chase, UBS and HSBC – charging them with notice of Madoff’s irregularities even while profiting from their proximity as custodians, administrators and managers of the monies fed to him by investors (the FT’s December series is well summarized here).

The former is of interest at least as a matter of social behavior and norm-setting. The latter will have reverberations with effect on the relationships between banks and other intermediaries and their own gate-keepers, including their auditors.

Barbara Picower faced this dilemma: She could have spent the rest of her own life defending against Picard’s suit, fighting uphill to protest the conduct and virtue of her spouse – who, charitably accepting her own claim of innocent ignorance of Madoff’s scheming, confronted the plainly demonstrable character evidence of his propensity to cheat at golf (a favorite post with readers from March 2009 is here).

Or – presumably able to live in adequate comfort on her bequest from Jeffrey of $ 200 million, and thus dramatically re-calculating the magnitude of a “widow’s mite” – she could launder her own status with a dramatic gesture of civility and largesse.

Secular sainthood is seldom so available – and with nary a hungry day either.

The noblesse of the widow Picower has made life less pleasant for Madoff’s other A-list clients. Those like Picower, close enough to finger the tattered edges of his moral fabric, are now forced to choose. They can oppose Picard’s claims to claw back their ill-gotten returns, under the shadow of the widow’s precedential capitulation. Or they can join the settlement queue – although not cushioned by the generous inheritance she enjoys, and to be seen only as belated converts, never to enjoy the halo effect she obtained as first-mover.

Depending on his trawl through Madoff’s client list, Picard is now working on a shortfall of some $10 billion. Of that, it says here that he will extract on the order of $ 1 billion from HSBC alone – precisely on account of the roadmap to its liability provided by the due-diligence engagements performed for the bank by KPMG in 2005 and 2007 and roundly ignored. It’s a plaintiff’s dream and an evidentiary nightmare for the bank that, prediction suggests, HSBC will pay handsomely to keep far away from a trial.

There’s more here, though: The KPMG engagements are a roadmap not only to what was done for its client, but to what could have been done for the other enablers targeted by Picard. Therein will lie a tale for the courts – and another set of eight or nine-figure contributions eventually to reach Picard’s collection basket.

But now for the broader questions: What if HSBC had taken KPMG’s work to heart. Or the other banks and feeder funds had engaged credible due diligence by their advisers on accounting, auditing and controls? Madoff’s pyramid would have been toppled before it reached pedestrian levels.

Suppose by extension, while we are at it, that Lehman Brothers had asked E&Y for a critical study of the exposures lurking in its use of repo derivatives to window-dress its balance sheet? And actually acted on it?

Or that Daniel Bouton at Société Générale had re-deployed a portion of his bank’s costs of external audit to give actionable scrutiny to the corrupted back-office operation that was so expensively exploited by rogue trader Jérôme Kerviel?

Or that AIG had given credence to a state-of-thinking study of the non-correlated nature of the inter-connected structure of the global CDO market?

Instead of the risk management possibilities of available but unavailed sources of wisdom, these institutions continued to subscribe to the one-page, bog-standard commoditized reports that regulators require from auditors – to be ignored in good times, because they convey no value regarding non-problematic operations, and useless for the detection and prevention of catastrophic events in bad. 

It’s a closed and obsolete system as bankrupt as Bernie Madoff himself. In the entire cast of characters, Barbara Picower emerges so far as the best of the whole sorry lot.

 

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Merry Christmas 2010 -- And a Happy New Year to All

 From civilization’s very beginnings, tribes in the north came together on the shortest day of the year, to gather evergreens and build fires and chant petitions to their deities for the return of the sun and warmth on which their survival depended.

Their empirical observation -- that the light did return -- induced them into the spiritually understandable if logically flawed conclusion that there was a causal connection with their rituals.

Which we continue in today's no less challenged time -- this year with the extra benefit of a full lunar eclipse – although now the lights are low-energy LED, the greenery is recyclable and correctly fire-retardant, and the celebrations are as diverse as our widely scattered traditions. And, to confess, we are occasionally diverted from paths of consciousness by the relentless merchandising of redundant consumer expenditure.

This winter solstice, our own family will join at our church in the dark evening’s memorial for the homeless. We will then be at Mass on Christmas Eve, exercising in faith and joy our nation’s freedom of religious practice, and will be with relatives the next day for gifts and feasting.

However you may choose to observe the compelling promise of annual renewal, it is a time to express gratitude for good fortune, to contemplate in our abundance the condition of those whose sufferings we can do something to relieve, and to dwell in brief quiet on the potential to realize peace on earth.

With thanks for your interest and engagement through a difficult 2010, and best wishes to all for a healthy and rewarding new year.

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Book Review: Tony Judt Has a Few Last Words

Ill Fares the Land, by Tony Judt, Penguin Press, 237 pages

“Ill fares the land, to hastening ills a prey,

Where wealth accumulates, and men decay."

-- Oliver Goldsmith, The Deserted Village, 1770

Although I had devoured Tony Judt’s sweeping prize-winner, “Postwar: A History of Europe Since 1945” (2006), I had missed the April release of “Ill Fares the Land,” for which I am obliged to a regular reader.

If there is reason to celebrate Judt’s ability to bring forth his extended essay under the terrible burden of his terminal battle with ALS – and there is – it is no less lamentable that his premature death in August removed him as promoter and advocate on its behalf.

Even if some months late to the task, I am impelled by the strong suspicion, much as I would love otherwise, that this space shares few enough readers with Judt’s regular platform, “The New York Review of Books.” 

Judt paints with eloquence the debased world of “conspicuous consumption of redundant consumer goods” – enabled by the retreat from the postwar achievements of interventionist governments in areas of security, prosperity and social services. Instead are the unprecedented wealth disparities of the last thirty years, especially in the United States and the United Kingdom but throughout advanced economies globally, with all the attendant costs and consequences falling disproportionately on the increasingly disadvantaged: social alienation and depression, failed education and mental and physical dysfunction.

Judt points to the confusion sown by self-interest pursued and based only on maximized individual economic advantage, with “minimal reference to extraneous criteria such as altruism, self-denial, taste, cultural habit or collective purpose” – even while the advocates of unregulated free markets drove into the abyss of the credit crisis of the last three years under the “false precision” that because “they didn’t know everything, as a result it turns out that they didn’t really know anything.” 

As Judt sees it, the reduction in trust and cooperation on which the social cohesion of the modern state critically depends, has given way to policies driven by fear, selfishness and bigotry – manifest in communities segregated and gated-off both physically and culturally. The ominously frightening consequence, when government cannot function on trust, is that it will move to do so by intrusion and repression, and ultimately by violence.

In the way of polemicists since Jeremiah, Judt in his outcry for a new form of social discourse does stop short – or so it could be charged, by those for whom words of inspiration only come alive in action. For his rhetoric flags, both on the particulars of a process for a new form of engagement across the spectrum of political principles, and even more on the blueprint by which the headline topics of a just and caring society might be realized.

Which takes nothing away. Voices on Judt’s behalf need to be raised, post mortem. His legacy is one of those small works that emerges from time to time, well ahead of the readiness of even sympathetic audiences to grasp its ultimate impact.

To punch its weight, however, would not have meant stints on the Oprah show or Comedy Central. Even writing for an American audience, Judt has a style, exemplified by his use of both diacritical marks in the word “dèbâcle,” that must have prepared him for an underwhelming reception in the popular audiences.

Which is fine. “Ill Fares the Land” was never destined for wide readership. The population of conservatives genuinely qualified and inspired to engage a substantive conversation with its content could probably convene in a closet; other pretenders on the Right would fall among Judt’s targets as having prospered personally – he would say, selfishly – from the subsidies and support of the active operations of government through the course of “the American century.”

Meanwhile, know-nothings at both ends of the political spectrum will not appreciate a work demanding more cerebral engagement than Fox or MSNBC, nor will they stick with the task of reading to chapter two without their lips getting tired.

For myself, I happily leave to the professional ideologues the debates over the relative analytic purity of Judt’s vision for a renascent substantive form of civic engagement.

Here’s the thought: take an evening off from the cacophony of the electronic media, and invest the time and mental effort to wrestle with these messages. When a sufficiently receptive audience has done that, the process will be well begun of extending the foundations for a sustainably re-envisioned global society of both compassion and decency.

 

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Dodd-Frank Lets Small-Company Auditors Off the Internal Controls Hook: Putting a Partial Lid on the Sarbox

At least one piece of the Dodd-Frank legislation now has a ribbon neatly tied around it: the Securities and Exchange Commission has issued its rules to exempt small companies – generally those with less than $75 million of common equity – from having a separate independent auditor’s report on their internal control assurance under Section 404 of the Sarbanes-Oxley law.

(For her customarily concise and lucid summary, see Edith Orenstein’s FEI Blog.)

I’ve been quiet on Dodd-Frank. Why not? Unmanageable in its creation, incomprehensible in its enactment, unpredictable in its consequences, as it was. Who could work up an appetite to ingest such a pigs’-breakfast of law-making?

Small companies may say, with the night watch in Hamlet’s Elsinore, “For this relief much thanks.” But marginal tinkering with the mis-begotten obligations of Sarbox 404 will matter less, and for different reasons, than are usually put on view.

To start, the toxic post-Enron environment in which Sarbanes-Oxley was enacted in 2002 has effectively immunized its impositions from critical cost-benefit evaluation. Persistently asking the wrong question – “Has the quality of corporate reporting actually improved since the days of WorldCom and HealthSouth?” – not only ignores the built-in cyclicality by which outbursts of scandal are purged by self-cleansing returns to virtue. It also leaves unasked the proper question: “Is that reporting better than if Washington had done something else – including doing nothing at all?”

More importantly, can any scarred survivor of the last three years of Bear-Lehman-Fannie-Freddie-AIG-Merrill – the most disruptive economic period since the Great Depression – argue seriously that auditors’ reports on the “out-of-controls” of those fallen industry giants actually made any positive contribution to systemic safety, stability or credibility?

In that dreary context, of course, it makes perfect rational sense to give small companies a “Get Out Free” card.

That’s because, as I was advised about parenting strategy when our daughter was born: “Little kids, little problems; big kids, big problems.” A new father’s worries escalate, from the essentially trivial inconvenience of an infant’s colic or spilled oatmeal, on to little league injuries and a teenager’s driving safety, up to college admission and the launch to the challenges of adulthood.

In the same way, the fewer zeroes on a balance sheet, the lessened likelihood of systemic impact of mis-behavior that makes a difference. “Out-of-control” at a Koss or an American Apparel may be inconvenient for a limited constituency, and provide grist for the mill of the plaintiffs’ securities class action lawyers – but otherwise doesn’t matter in the great scheme of things. It’s altogether different when the entire global financial system can seize up under the effects of a threatened, undetected and undeterred collapse at an AIG or a Lehman.

History and experience teach that regulatory systems designed and applied under motives of political correctness over the fat part of the compliance curve are wasteful and ineffective – whether aimed at school truancy, auto emissions or corporate disclosures. Instead they will fail to identify and address the “outliers” that actually prove disruptive – the SEC’s sorry performance in regard to Bernie Madoff and Allen Stanford make the case. 

Section 404 reports on small companies were never any more likely to be effective by way of detection or deterrence for small companies than they have proved for the large. So it was an inevitability that inflicting Sarbox 404 auditor reports on small companies would have been largely an exercise in even further futility. If regulation has not worked for the big and dangerous, in other words, how can it be good or useful for the small and irrelevant?

Drab as it may seem, finding negative comfort that at least our legislators have stumbled into a way to avoid making a weak situation even worse, there is both logic and benefit in leaving bad enough alone.

 

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Does Anyone Really Want to Be an Accountant? A Tailgate Survey

Last Saturday I was part of that great autumnal experience – tail-gating and a football game at a major American university.

For non-US readers perhaps unfamiliar, the rituals partake of religious cults: Adherents converge in vast throngs, dressed in exotic pilgrims’ vestments of bizarre colors. They drink copiously of the sacred brew, they invoke the spirits of sunny weather and the glow of victory, and they noisily exhort their muscular youth to inspired feats of glory.

Secondary to its storied gridiron history, this school is also a major supplier of feedstock to the accounting profession’s voracious appetite for new recruits, through its large departments of accounting and finance.

So because my generation’s children have grown to be college students and fresh alumni, the convivial afternoon gatherings around grills and coolers in the stadium parking lot also gave a chance for some rough field research on that age group’s attitude toward their studies and the state of the profession’s process of self-renewal – first-hand inquiry of bright young graduates prepared for the bottom rung of a new career ladder.

Caleb Newquist, Francine McKenna and the Junior Deputy Accountant give a lot more attention to the dynamics and travails of the firms’ recruiting and retention issues than I can. But the results of four discussions amid the marching bands and the waving pennants, although plainly anecdotal and unscientific, do give pause:

• One new accounting graduate, having spent a Big Four internship assigned to the box ticking of Sarbanes-Oxley compliance work, was bailing out on debits and credits altogether and re-orienting for law school.
  
• A second, well into a master’s program under-written by a large firm where his job offer awaits, is primarily motivated to obtain his degree and pass the CPA exam by the salary bonuses that are promised at each step.
• The youngest new alumna, celebrating her last weekend before reporting to be junior audit staff in a major-city office of another of the Big Four, expressed her ambiguity in the phrase, “My life is about to be over!"
  
•  Meanwhile the eldest of the group, an ex-survivor of three staff years in yet another large firm, is wildly happy having moved to a new position as financial controller at a division of one of her former clients.

A large-firm leader once put it to me that the main purpose of hiring new university graduates is to cultivate staff accountants to become the next generation of managers and partners. If so – although the depth of malaise revealed by my brief survey of this decade’s best and brightest may not generalize – neither is it cause for confidence in the profession’s ability to stay on top of the talent level demanded for the retention of its reputation and credibility.

Those engaged with both our students and our future are advised accordingly.

Postscript:

Our celebration took place at a leading church-affiliated school, seriously conservative in its theology, culture and politics. Although it would never condone the burning of a Koran, it is likewise not likely to permit the opening of a mosque on its campus any time soon.

For all the atavistic hoopla around the game, Saturday was also the ninth anniversary of September 11. It was an affecting moment, to stand with 80,000 people in a moment of silence for all the casualties of that awful day, to join in a prayer of remembrance, and to unite in the nation’s anthem while our flag was raised high and lowered in honor to half-staff.

In that context, the home team’s inability to hold off the visitors’ last-minute scoring drive for the win seemed not to matter quite so much.

 

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Business Models and the Search for Success: A Tale of Two Cities' Bicycles

 

Summer’s over. And with the fresh school term, I’ve started a very exciting new teaching gig -- “Accounting & Finance” at the Northwestern Law School in Chicago.

The proposition for law students is compelling: Just as any adviser or advocate requires the tool of literacy to access the verbal wisdom of treatises and books and briefs, the ability to engage with significance anywhere in social and commercial enterprise requires basic familiarity with the grammar and syntax of quantitative financial information.

Our first class pitched right into the topic of business plans, the tools for searching out sustainable business value, and the assessment of business decision-making as supported by the integration of strategy, investment and operations.  

For which, the week’s news was rich with pedagogic opportunity: BHP Billiton’s hostile play for Potash Corp., HP’s extravagant out-bidding for 3Par to steal a competitive march on Dell, and the optimistic willingness of three wealthy Brazilians to stump up over $3 billion in hopes that Burger King can be flipped one more time.

With all that context, the curriculum probably lacks time for this comparison of two business models – which is too bad:

During our recent extended stay in Paris, I made extensive use of the Velib program – the network of urban-designed bicycles rolled out in 2007.  Launched with 10,000 bikes at 750 stations across the city, it has doubled in three years – there is a station every 300 meters across the city, with 75,000 daily users and twice that number each summer weekend day.

As a basic part of its business plan, the program incentivizes short trips -- the first half-hour is free. I easily earned out my € 29 subscription – one morning using five different bikes to cover appointments from the 5^th to the deep 16^th and back.

So I was bemused, at the end of the summer, to see a proud announcement heralding the start of Chicago’s B-Cycle: six stations between the John Hancock and McCormick Place, and a grand total of 100 bicycles.

This is not a business plan that can be substantively real – but only an illusion of long-term sustainability and success.

For example, the Chicago program promotes the notion of commuter usage (here). But there is no access at the commuter rail stations. Nor in the critical population centers of Lincoln Park, Wrigleyville or the South Loop. Where are the bikes where the potential riders are – Old Town, Lincoln Square, the Clybourn Avenue corridor? Or to serve the student population – on the campuses of Loyola, DePaul or UIC?

Velib launched in Paris with critical mass, sufficient to have an impact on its urban lifestyle. My friend, a senior executive at the OECD, promptly sold his car; he uses Velib to commute except in extreme winter, when his cost to take an occasional bus or even a taxi is a minor offset to his overall savings. 

The business plan is familiar: when Fred Smith prepared the debut of Federal Express in 1973, not a plane flew nor a package moved until he had coverage of 25 cities – enough to re-shape an entire national business culture.

Velib does have issues – vandalism is higher than expected, and to manage uneven usage around town, there is now a rewards program for riders who return bikes to high-demand stations. But the program is here to stay. The Velib website is attractive and informative (here). There is an iPhone app for news and station locations. And in characteristic French fashion, this spring a comité d’usagers was selected as an official forum and sounding board for riders’ concerns.

On the commercial side, the advertising giant J.C. Decaux, which sponsors the program in exchange for the advertising opportunity, is in it as a business –complementary to the city’s political agenda of reducing private auto traffic and pollution.

Weather in the Windy City is not conducive to a year-round bicycle program, of course, no more than it is – regrettably -- to credible year-round artisanal markets. Chicago may lure the occasional summer tourist to pedal the shoreline of Lake Michigan, a precious resource that Paris cannot match -- although even there, the quais are entirely closed to cars on Sundays. Lake Shore Drive should be made so people-friendly!

Just before the summer ended, I took Velibs back and forth from our apartment in the 6^th to the supermarché across the Seine, to buy dog food and olive oil. Until Chicagoans can use B-Cycles the same way – to work, and for errands within a 20-minute riding radius – it is not a credible plan, but only a costly publicity stunt.

 

My thanks to our daughter Julie for her Velib research, done for a project for her Environmental Studies class.

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Lessons in Risk Management: A Hierarchy of Learning from Ignorance

The seemingly indestructible baseball legend Satchel Paige asked, “How old would you be, if you didn’t know your age?” *

I’ve worked during this summer vacation to review and refresh the syllabus of my MBA-level course in risk management and decision-making, where the related question is, “How smart can you be, if you don’t know your own ignorance?”

At its core, the course seeks to identify potentials for success, from the lessons of failure. Recent weeks have provided an abundance of “teaching moments”:

• Tony Hayward’s long-postponed but inevitable defenestration as CEO of BP – another demonstration that public perception of a tone-deaf executive’s culpability will prevail – incidentally inflicting major collateral harm to what had been an advancing discussion on the benefits of splitting the roles of corporate chairman and chief executive.
• By contrast, Goldman Sach’s achievement of a speedy and affordable settlement of the SEC’s suit over a toxic subprime mortgage-based derivative product, for the relative pittance of $550 million. Love or despise the “vampire squid” – Goldman will survive and thrive in no little part for its ability to maintain both calm and quiet under pressure, keeping beneath the flame-throwing and appreciating the benefit of avoiding additional fueling of the short-lived news cycle.
  
• The release by WikiLeaks of a massive volume of raw documentation from the Afghanistan war. The trove will be well-combed by future historians, but even on a superficial reading of the official manipulations, naïveté and mendacity, the fundamental lessons remain unlearned -- from China, Algeria, Viet Nam and Afghanistan itself -- that short of annihilation, no level of mighty foreign military technology will prevail in a house-to-house conflict against forces able to blend seamlessly into a village-level local population.

Thinking with students about these scenarios, with special concern for the availability of awareness and action in time to actually affect an outcome – that is, before the inflection point at which a threat tips over to become a disaster – there emerges a kind of hierarchy of learning opportunities. Consider: 

• As the last of the helpless dinosaur population dwindled around the tar pits, while tiny furry mammals disported at their feet, the combination of climate change and evolution reduced their survival chances to zero.
• Innocent species lacking defensive measures were equally doomed – including those wiped out by humans, from carrier pigeons to the great whales.
  
• Human societies also innocent in their ignorance have doomed their viability – whether the Easter Islander destroying their only timber sources to replace their great canoes, or the Greenland settlers unwilling to adopt the diets and hunting techniques of the natives (see Jared Diamond’s “Collapse,” 2005).
• Further up the ladder of chargeable responsibility is the blinkered denial built into herd behavior – no better exemplified than by the last-gasp claim of Citigroup’s Chuck Prince in the summer of 2007, that, “As long as the music is playing, you’ve got to get up and dance.”
  
• And finally – or at least to stop just short of conduct warranting indictment – there is the evidently deliberate and self-interested exploitation of the credulous, wrought by Goldman and its now-isolated foot soldier, Fabrice Tourre, in designing a financial derivative with characteristics maximizing its likelihood of failure.

As I would like my students to learn from such an array, in daily life no less than in the classroom, the ability to avoid the next problem is measured by the capacity to take heed from the last. 

*My review last May of Larry Tye's delightful biography of Paige is here. 

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The Big Four's UK Firms Pick Up Non-Executive Directors -- And Then ...?

All the girls get prettier at closin’ time –

                    Mickey Gilley, 1976

A recent discussion with Re: The Auditors about the governance of the large global accounting firms was triggered by the UK news that the Big Four were appointing non-executive directors (here), as contemplated under the Audit Firm Governance Code published in January by the Financial Reporting Council (here).

Francine McKenna’s blog post (here) included my own skeptical two cents worth, on the unlikely effect on the culture of global-scale private partnerships, and the limited impact of single-country endeavors. It also led to these further pessimistic reflections on the reasons why the FRC’s efforts – however noble and well-intentioned – will create no traction in favor of the firms.

A starting point is with the process itself: a task force was assembled under the auspices of the auditors’ own trade group, the Institute of Chartered Accountants in England and Wales, comprising four members from the accounting firms, seven from large clients and a single academic. So as to the question of “regulatory capture”:

Would you expect roast goose for Christmas dinner, if the flock got to vote on the menu?

More important is a proper apprehension of the role of codes of conduct and ethical charters and all the accompanying high-toned rhetoric. It’s the common confusion of cause and effect, to view these as drivers of responsible corporate governance.

The contrary is readily observed. Governance-challenged enterprises from Siemens to AIG to BP could claim the vigor and piety of their pre-lapse structures, and Enron was lauded for years as an American model of behavior.

The FRC’s code (here) rightly identifies the importance of executive “tone at the top” – but its induction runs the wrong way. In truth, when company leadership really does “walk the talk,” its employees are infused and its community is served in praise-worthy fashion -- codes and charters follow with credibility.  

Not only can good governance not be inflicted or imposed, in other words, because resistant leaders will find ways to disturb or subvert the purpose, but a virtuous culture will display its legitimacy without the need for pietistic overlays.

So the FRC is on the back foot in at least these ways:

First, the Code makes persistent reference to the non-executives’ presumed “independence,” but recitation and reality do not engage. As contemplated, newly-engaged worthies will be compensated under employment contracts, provided with staff and resources by the clients, and insured and indemnified for their conduct – putting them under far closer relationships than the large audit firms are permitted themselves.

Second, the FRC proposes that non-executives might facilitate communications and reduce exposures when the large firms face existential threats from litigation, regulation or prosecution. As floated briefly at the US Treasury Committee on the Audit Profession in 2008, the suggestion of stand-by management replacement under similar conditions displayed a Panglossian naïveté that thoroughly deserved its criticisms (here). But rebuttal need not go so far. If “tone at the top” is to be successful in a crisis, it has to be engaged first-hand – not insulated or protected by proxies, delegates or intermediaries.   

Finally, the Big Four firms already have an agenda of opportunities to address the credibility gap with their critics, none of which involve the cost or distraction of bloating their boardrooms with outsiders drawn from the available ranks of the great and the good:

• Arguments about the safety and soundness of the Big Four are going nowhere without their publication of audited world-wide financial statements. Single-country information, of the type now available in the UK, leaves unaddressed the implications of strategic directions, personnel deployment and risk and quality exposures that span the globe.
  
• No progress is possible toward a sustainable business model resistant to deadly litigation exposure, so long as the large firms limit their advocacy to summary data and hand-wringing by their messengers -- as witness the sterile paralysis of the Paulson Committee (here). If inflicted on a Big Four firm, the $ 3 billion cost-to-date of BP’s exposure to Deepwater Horizon would already have been fatal (here) – a message supportable only by an available public acknowledgement of the specifics of the large-firms’ list of death-threats.
• Relatedly, it is past time to recognize that the energy devoted to narrow-focused “liability reform” and “damage caps” is a wasted effort – not only as a political non-starter in every major legislative venue, but as unsatisfactory to achieve sustainability. Legitimate structures for investor protection cannot in the long run be built on the narrow base of the accounting firms’ partner capital – the resources are simply not there – but require instead the presence of government as a resource of last resort.
  

To the extent any of these require more fundamental re-engineering than that offered by the FRC and the ICAEW – and they do – so be it. 

 

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Happy Vacation -- Even the Crooks Are Taking a Break

When a felon’s not engaged in his employment,

Or maturing his felonious little plans,

His capacity for innocent enjoyment

Is just as great as any honest man’s.

-- Gilbert and Sullivan, “Pirates of Penzance,” 1879

I’m about to be off for several weeks, for that nearly-sacred ritual of summer holiday, so beloved in Europe and observed with enthusiasm.

Predictions of the unexpected that might arise while I’m gone are impossible, of course: human mis-handling of complex events ranging from BP’s Deepwater Horizon to the Gaza blockade to the quality of World Cup officiating show that timing pays no respect to environmental disasters or tribal violence or even soccer’s off-side rule.

But reasonable expectations are that life may be calm for a while at least in the space that is watched over here. 

That’s because:

• The world of financial information and public accountancy was left untouched either by the Dodd-Frank regulatory legislation now clanking toward passage through the U.S. Congress, or by the Supreme Court’s ruling on the constitutionality of the Sarbanes-Oxley law (here)
  
• Invited to inaction, then, rather than to further public mischief-making, American legislators are now off for the summer to abuse their subordinates or their constituents or their expense accounts.
• Summer is not typically the time for the eruption of financial scandal, which is rather pressured into public view by the stresses of year-end reporting and the eventual and unavoidable escalation and collapse of Ponzi-style machinations.
  
• Instead, the next generation of white-collar financial criminals are beavering away, beneath the screens of visibility, always and ever searching out the exploitable weaknesses in the world’s fragile systems of corporate governance and reporting.  

So, while it is no time for naïveté or diminished diligence, it may justifiably be time for a little pause. The challenges of this fall’s new season of discontent will arrive soon enough – so enjoy the summer while we can.

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Drilling Down Into BP's Risk Management: A Process As Blown As The Well

“I never went to bed with an ugly woman. But I’ve sure woke up with a few.”

-- Country songwriter Bobby Bare

The failure of BP to “top kill” the Deepwater Horizon well brings to mind Blaise Pascal’s difficult question, how to strategize the unanswerable question whether God exists.

As he came out, to assume the positive and be right is marvelous, and to be wrong is of little effect; to assume the negative and be right is no worse than neutral – but to be wrong is damning.

Looked on as a matter of risk management – rather than as a much-debated philosophical or spiritual conundrum – Pascal’s challenge sits on top of the list of lessons from the events just ahead of the catastrophic blow-out in the Gulf of Mexico.

That is, if it were a final examination question in my MBA class – where we search for the lessons from failures in decision-making across a broad range of business and personal activity -- it would be hard to improve on the Deepwater Horizon disaster. The catalog of avoidable errors in analysis and performance is long and troubling – for example:

• Increased safety measures can mask heightened risk, especially where early signs of trouble are ignored as “close calls.”
• Increased complexity of technology alters the risk profile at the frontier of safety margins. 
• Management over-ride of on-the-spot warnings discourages honest communication and conceals bad news under the pressure to deliver success.
• Group-think and herd behavior are exacerbated by the over-confidence that mistakes past achievement for future safety.
  

Briefly put, the central theme in BP’s failed process was the consistent mis-measure, in its concededly risky choices, of Pascal’s potential up and downside gains and losses – related to what the statisticians confuse us all by referring to as Type 1 and Type 2 errors.

Examples abound, from the modestly consequential to the highly destructive. Consider:

A driver is low on gas. If he chooses to stop immediately, he gains the certain security of a full tank, foregoing the possibility of a modest savings. Whereas, if he carries on in search of a station with a lower price, his maximum upside is a few dollars gained, but his downside is to be marooned awaiting rescue by the roadside, or worse.

Or this: The space agency NASA must decide whether a shuttle launch can safely proceed in cold weather. Postponement to a warmer day means a modest loss of time, for the sake of mission safety – whereas pushing for a “go” decision can at best achieve budget and reputational success, but only with the risk that the frigid conditions will cause an explosive failure of the rocket’s booster (q.v., the 1986 loss of the shuttle Challenger and the lives of its seven astronauts).   

How extensible are the lessons of BP’s questionable decisions – the use of a riskier well casing, under pressures of time and budget, or the premature substitution of lightweight seawater for heavier drilling fluid, under delays costing $500,000 per day (here)?

At the level of individual risk tolerance, consider two insurance scenarios: Taking a pass on auto collision insurance saves the premiums, and puts at risk only the replacement cost of a total wreck. But choosing not to buy long-term health care insurance runs the uninsured risk of a debilitating and devastatingly expensive illness.

Or for investors: excess portfolio concentration in pursuit of incremental performance ignores the question, “How bad could this possibly get?” – as learned to their sorrow by Bernie Madoff’s clients and employees with their savings in Enron’s retirement program.

Consequences vary. Pick a bad restaurant, and the only loss is an evening’s sub-standard dining. But fail to hedge a naked short, and the losses could be ruinous. 

Corporate risk management depends for success on similar decision-making dynamics: Is a bet-the-company strategy acceptable? Is it even recognized?

Whatever the assessments made by Bear’s Jimmy Cayne or Lehman’s Dick Fuld or Countrywide’s Angelo Mozilo, they mis-evaluated their exposures to disastrous downsides – no less than the bureaucrats of NASA or the over-seers at BP.

On the other hand, betting Pascal’s wager the wrong way risks the wrath of an angry deity – which in the long run may be worse.

 

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Trust Matters: Charlie Green and I on Ethics Training, Corporate Standards and Society's Limited Expectations from Government

I talk often with Charlie Green -- author, speaker and consultant, and expert on the theme of trust in business relationships. His blog, Trust Matters, is a ready and regular source of wisdom.

We spoke at length this week, on a broad range of related subjects. Charlie has posted the interview as the latest in his series of Trust Quotes. Here are several excerpts:

CHG: What concerns do you have about the effectiveness of teaching about trust, ethics and governance in the business schools and universities?

JP: It’s my belief that much of the teaching is at best ineffective and at worst a misleading waste of time – although I am sensitive to the way this is received among my colleagues in academia. Jeff Skilling and Andy Fastow were celebrated as executives to be admired, and either one would have scored an A+ on any university-level course in ethics or governance.

****

CHG: Both “doing good” and “doing well” are byproducts of a cultural devotion to doing business from a certain set of principles? Care to say something about what those principles look like?

JP: One of the finest defense lawyers I ever knew, the late Peter Fleming, had nothing but scorn for elaborate codes of behavior – governance, accounting principles, whatever. His guidance required one page: “Can you credibly defend this decision in front of a jury?”

****

CHG: What can we reasonably expect from government by way of contribution to good corporate behavior?

JP: I’m a deep skeptic on the ability of regulators to either detect or to deter bad behavior. Not that oversight and enforcement are not necessary. But it seems to me pretty clear that the post-Enron imposition of Sarbanes/Oxley did not lead to an outbreak of virtue.

Look at the many examples over the last three years....Law enforcement is by nature always going to be reactive, behind the curve of the inevitable misbehavior of those who would burst the limits...It goes back in part to why societies evolve their laws and codes of behavior. People don’t become law-abiding because more laws are passed.

I invite you to the interview in its entirety. And Charlie and I would both welcome your reactions and comments.

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Goldman Sachs and the Fabulous Future of Fabrice Tourre

Is there a future at Goldman Sachs for Fabrice Tourre? The self-styled “fabulous Fab” was the only individual clipped as co-defendant in the suit by the Securities and Exchange Commission over Goldman’s late 2006 flogging of the exotic financial derivative Abacus, a credit default obligation based on a portfolio of toxic subprime mortgages.

Tourre is now safe-housed in London -- Goldman having evidently taken the strategic decision to keep their erstwhile wonder-boy clasped in close embrace for the duration of its legal exposures. 

For which, by contrast, compare the unpleasant consequential exposures for Société Générale, whose rogue ex-trader Jérôme Kerviel’s just published tell-all, “L’Engrenage, Mémoire d’un Trader”, re-ignites the early 2008 agony of his multi-billion euro infliction; or Arthur Andersen’s ready disavowal and jettison of Enron engagement partner David Duncan, before its own flame-out in 2002.

It would be inductively flawed for Tourre to assume continued enjoyment of his employer’s long-term hospitality. Thanksgiving turkeys, fattening in luxury through the autumn, learn to their dismay of the radical adjustment in their life-style when the farmer’s late-November strategy brings down the axe. Equally, Tourre’s useful life at Goldman is tied entirely to the resolution of its concerns with law enforcement.

So, being well-advised, he should expect to become chum for the sharks either as part of a settlement or directly thereafter.

Unless of course he can prove his present value by re-programming the energy with which he hawked the Abacus product to Goldman’s ready market of credulous believers. 

And how? The British bookmakers have already captured the odds-making on the survival prospects of the Tory/Lib Dem coalition. This year’s action on the NCAA basketball tournament is over. And the consequences of BP’s blown well in the Gulf of Mexico are priced into existing petroleum futures.

Other exotic alternatives? Given the volatility of emerging information about the organized church, arising from Chile to Germany, what about “clerical futures,” tied to the predicted tenure and turn-over of a portfolio of Catholic bishops, or the likelihood of Episcopal schism based on gay ordinations?

Or perhaps a wager on the total first-year sales volume of Apple’s iPad – directly tied to the roll-out of the device itself rather than the prosaic proxy of AAPL’s stock price?

Or here: our cultures now encourage wagers on the duration of life itself, through life insurance, viatical settlements and reverse mortgages -- and pre-nuptial agreements are increasingly used to manage the business side of romantic associations. Do the investment bankers’ innovators not see an unexploited niche market for financial products tied to the durability of marital contracts?

A full range of investment opportunities should be available. A customized wager on the likelihood of the neighbors’ break-up would require frequent re-pricing, depending on the level of loud arguments and broken crockery. By contrast, standardized trades could be tied to the five-year intervals celebrated in the etiquette books – call them “anniversary futures,” denominated wood, tin, pearl, silver, and golden, and priced accordingly.

The records of the domestic courts would also make historical data available to underpin trading opportunities in “marriage pools” -- say, by parish or profession or income level -- with divisions into tranches and risk ratings differentially assigned and priced. 

Consider the risk-disclosure language in the offering documents: triple-AAA ratings for the likely fidelity of a group of unadventurous stay-at-home actuaries – or junk-level assessment for the ten-year prospects of wander-lustful professional golfers or soccer players or elected officials.

These ideas might generate a certain reticence among portions of the investor community. Betting against the probity of the local clergy might infringe some sensitivities. Hard-core adherents to the sanctity of life-long vows might be uncomfortable taking bear positions. But no more so than the occasional unease with the role of short-sellers in the equities markets – recalling that nobody actually forced Goldman’s clients to buy those doubtful-looking CDO’s.

A host of small details would remain to be worked through – whether insider status would extend to clergy or divorce lawyers, for example.

But these are small concerns, and “the Fab” has time on his hands. 

Unless, being smarter than a turkey, he is already busy trading the over/under on his departure date.

 

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The Future of Goldman Sachs: Sound, Fury, and the Human Appetite for Risk

 

If correctly read, the thermometer on the temperature of the body politic suggests that the public fever of the last weeks on the SEC’s charges against Goldman Sachs has broken.

A reader expressed her cooled reaction to Goldman’s design of an exotic, tradable mortgage-based product on which the shorts and longs were symmetrically affected: “Why not – after all, that’s what they do!”

It’s not just Warren Buffett's avuncular cheerleading at the Berkshire Hathaway shareholders’ meeting in Omaha, however directly interested, or the related embrace of the mainstream media (for both, see the NYT’s Andrew Ross Sorkin on May 3, here).

More, the brevity of public attention proves again Samuel Johnson’s 18^th century observation that “nothing focuses the mind like a hanging” – whether the present dependent subject is the British Parliament, BP’s oil containment efforts or the Greek noose around the neck of the Euro.

As it moves off-screen, Goldman’s future does not depend on the usually attenuated inter-connections between Main Street and Wall Street. It will lie, rather, in the hands of law enforcement officers, whose reputation enhancement will incline them to nick off a pound of flesh or two and move on to resolution; legislators ready to take up other posturings; and, especially, clients and trading partners whose self-interest will be well served by Goldman’s robust survival.

Which, the more I ponder, is as it must be.

Populist outrage at the business model behind Goldman’s esoteric designs always lack emotional coherence – the unease of those uninformed and unfamiliar with the operation of complex financial products showing again that a little information can be worse than none at all.

As the behavioral academics say, it’s very much to do with how the issues are framed.

For one example: conventional reaction would likely be negative in response to an opinion poll, “Would you support wagering on the length of a human life?”

Yet that is the entire basis for the life insurance industry, which – no less than Goldman’s Abacus product – is in the long run (costs, time value and enterprise profits included) a zero-sum proposition. Large pools of underwriters’ capital wager on the uncertain but ultimate timing of the inevitable mortality of those on whom the bets are made.

And a broad range of legitimately insurable interests are required – it only being frowned upon to allow, for example, the sole care-giver of a fragile elder to take a large policy for his own benefit.

Likewise, while the disconnect between aspirations and responsibilities played no small part in the foundational irrationality of the credit crisis, ownership of a family home has been widely promoted as a virtue. Meanwhile, despite the faint odor of disrepute not unlike that sometimes attached emotionally to short sellers in the equities markets, a niche market for reverse mortgages develops, by which the home equity of aged owners is bought out under pricing based on lifetime occupancy and actuarial expectancy tables.

Even at the personal level, the comparison has always been striking between motorcycle riders in America – who dutifully keep to their lanes although exercising a libertarian right to ride bare-headed – and those in France, for whom helmet compliance is inviolate but so is the chance to careen around traffic and down the dividers.

All of which shows that variations in risk appetites are pervasive, ranging from the ubiquity of casinos and lotteries to the cultural variations in personal safety judgments to the stream of innovations in mitigation techniques – whether product safety devices or hedging derivatives.

So while the particulars of Goldman’s innovations would, and will, outstrip the comprehension of its outsiders – beyond the atavistic spasms of short-term insult at the sheer amounts of money involved – its fundamental instincts are no different from those broadly inherent in the animating principles of human society in general.

In other words, they are part of us.

 

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Regulating Derivatives: After SEC vs. Goldman Sachs, Can You Keep Them Down on the Farm?

Whether and how to regulate the financial institutions’ creation and trading of exotic derivatives? Who should be enabled, or barred? Are there some so complex or toxic they should be banned? And critically – who thinks that Senator Dodd and his cohorts in the US Congress can sort it out?

I go back to the lessons on the farms of my youth.

It was an unvarying ritual: every evening, when the chores were done, my grandparents would convene to listen to the market reports, over the bakelite Philco that had pride of place on the kitchen table.   

It was especially important, when their feeder calves were ready for market, to have the daily cattle prices from the stockyards of Chicago and Omaha and Sioux City – because their timing had to strike a delicate balance. A driver and his truck had to be engaged. But commit to ship too early, and the animals would be under-prepared. Yet the risk of delay, for possible price moves, meant the possibility of being wrong, plus the dual impacts of extra feed costs and a loss of quality due to over-finishing.

By the time I was old enough to spell “cattle futures,” my astute grandfather was, through his commodities broker, hedging the on-the-hoof financial exposures that were out fattening in his feedlot – mitigating the random forces not only of market volatility but also pasturage and herd diseases and freight costs and all the malign hazards of a family farm.

What of his counter-parties? On the other side of his trades may have been Iowa Beef or McDonalds, or more likely a pure speculator – the zero-sum nature of derivatives trading made no difference to him.

The derivatives markets have known forever that at the end of the chain, some end user converts pork bellies to bacon and Brent crude to aviation fuel and even some of the gold into jewelry. But it doesn’t care. Grandpa’s fatted calves wound up as steaks and roasts and hamburgers, but trading regimes have never limited derivatives participation to packing houses and restaurant chains. Rather, a multitude of positions have evolved by way of options and futures, longs and shorts, insurance and hedges. 

And it’s equally true throughout the financial markets, where product innovation is one of capitalism’s articles of faith. Equity ownership in a single company begat the assembly of portfolios -- in turn democratized into managed mutual funds. From which it was no long step to the massively popular index funds, and thence to tradeable positions on the indices themselves.

Wagers of all varieties became available, on the movement of the S&P 500 or the FTSE 100, or sub-indices sliced and diced to the customized needs of the players big enough to ask. And the model is not only very far removed from actual ownership in the original underlying stocks – it bears considerable resemblance to the concoction by Goldman Sachs of a shortable product only distantly related to the houses temporarily occupied, before foreclosure, by the original subprime borrowers.  

Society has similarly concluded that the only requirement to sit at a gaming table is a stack of chips. The house will happily offer a chance to play, and to accept the money of the unsuccessful, without requiring proof of aptitude, or a working knowledge of the odds of filling an inside straight or bringing home an exotic roll of the dice.

Such dark pools of manipulated information as dog tracks and jai alai are allowed, for the entertainment of the tourists and the fleecing of the credulous. And local governments themselves peddle lottery tickets to the masses, against odds that would make a card shark blush.

In his hard-shell Methodism, Grandpa would never have set foot in a casino – he’d have scorned the frivolity and, more to the point, would have shunned an activity so far out of his capacity to comprehend and manage.

But allowed to live under his own principles, he’d have given taciturn tolerance to those engaged in legal if obtuse gambles.

Raised on the working end of a plowline and a pitchfork, and through a life driving a tractor and pitching bales of hay, Grandpa cultivated understatement and restraint -- along with an annual abundance of corn, beans and beef -- and never used two words when one sufficed.

His snort of derision would have been a wordless editorial -- “fool, to play a game you don’t understand.” But his own hard work and intelligent self-reliance would have respected the inevitability of creative innovation.

Rather than let a bunch of posturing politicians dictate or constrain his investment choices, he’d have let the markets decide which financial products proved their value, measured his risks, and taken his own advantage.

And so should we. 

 

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